Michel Rochette, MBA, FSA2009 SOA Annual Meeting         Boston    October 27th 2009
Topics  ERM and Solvency II     Similarities and differences between them     Purpose of an economic capital model    ...
Similarities  Economic capital models:     ERM: focus is on internal models only     Solvency II: SCR approach, partial...
Differences  Overall goal:     ERM: value creation through risk management     Solvency II: risk control through capita...
Differences  Risk Appetite:     ERM: essential as it guides firms in setting up risk limits and      tolerances. Focus i...
Purpose of an EC framework  ¨ Risk management system of an insurer for the   analysis of the overall risk situation of th...
Principles: EC development  All material risks should be covered: links to ERM and emerging     risks    Models must be ...
Major components  Exposure models of key risks:     financial risks & underwriting risks: assets and liabilities models ...
Uses    Investment decisions: existing and new    Product development    Strategic decisions    Corporate finance deci...
Validation principles  Integrates both qualitative and quantitative elements  Provides that the models were designed, wo...
Validation elements  Model development, design, implementation and   operations: similar to IT systems controls in place ...
Validation elements  Historical performance:     back testing to external sources: industry studies,      academic paper...
Calibration principles  For each risk drivers, should aim to calibrate four elements:     level of the risk factor and i...
Calibration by risk  Interest rate risk:     take into account the parallel , twists, inversion of the term      structu...
Calibration by risk  Credit, counterparty & asset risk:     in a total return context, spread risk anticipates future   ...
Calibration by risk  Life underwriting risk:     QIS4 mortality rate increased by 15% permanent with a 2.5 additional   ...
Correlation in the tail  Correlations exist at different levels:     within a risk category:           Market Risk Inter...
Correlation in the tail  Recent experience seems to indicate otherwise     According to a recent Pimco study:           ...
Correlation in the tail: lessons  Correlations are unstable in the tail and this what EC is   trying to determine  Indep...
Correlation in the tail: lessons  “When people start buying an asset, the act of them   diversifying ultimately makes the...
Emerging issues  EC must be a forward looking process , tied to ERM   and thus must anticipate emerging risks  Risk issu...
ERM: Emerging risk  Environmental risks – US based:     Fiduciary Responsibility: Legal and Practical Aspects of      In...
Solvency II: ORSA  Pillar II requirement: Own Risk & Solvency Assessment  Goal is to demonstrate “sound and prudent mana...
CONTACT      MICHEL ROCHETTE, MBA, FSA    ENTERPRISE RISK ADVISORY, LLC               954-607-6969michel.rochette@enterpri...
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SOLVENCY II & ERM

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SOLVENCY II & ERM

  1. 1. Michel Rochette, MBA, FSA2009 SOA Annual Meeting Boston October 27th 2009
  2. 2. Topics  ERM and Solvency II  Similarities and differences between them  Purpose of an economic capital model  Major components of a capital model  Uses of a capital model  Validation issues  Calibration issues  Emerging issues30/05/11 Enterprise Risk Advisory LLC
  3. 3. Similarities  Economic capital models:  ERM: focus is on internal models only  Solvency II: SCR approach, partial and full internal models  Governance:  ERM: many potential standards like COSO, SP ERM, ISO 31000  Solvency II: Pillar II with ORSA, governance and risk management functions  Implementation of ERM:  ERM: embedded in operations  Solvency II: Use test30/05/11 Enterprise Risk Advisory LLC
  4. 4. Differences  Overall goal:  ERM: value creation through risk management  Solvency II: risk control through capital, SCR and protection of policyholders  Risk taxonomy:  ERM: all risks with a focus on key risks  Solvency II: specific risks as defined in Pillar I and additional risks with capital add-0ns in Pillar II  Risk champion:  ERM: need a CRO to oversee all processes  Solvency II: actuarial function is defined and participates in setting up risk system, complemented by Audit and a risk function30/05/11 Enterprise Risk Advisory LLC
  5. 5. Differences  Risk Appetite:  ERM: essential as it guides firms in setting up risk limits and tolerances. Focus is on shareholders’ wealth.  Solvency II: focus is on the control of the negative side of risk through capital and policyholders’ protection.  Financial resources:  ERM: all financial resources available to face risks: existing and contingent capital  Solvency II: available capital: Tiers I, II, III  Value & time framework:  ERM: Economic basis, EEV, MCEV over a flexible time, two- sided VAR, TVAR..  Solvency II: target IFRS, over a one-sided 1-yr VAR30/05/11 Enterprise Risk Advisory LLC
  6. 6. Purpose of an EC framework  ¨ Risk management system of an insurer for the analysis of the overall risk situation of the insurance undertaking, to quantify risks and determine the capital requirement on the basis of the company specific risk profile¨ CEA Groupe Consultatif  Required capital is assessed in light of:  available capital & other financial resources  enterprise risk management processes  strategic goals & risk appetite  regulatory requirements30/05/11 Enterprise Risk Advisory LLC
  7. 7. Principles: EC development  All material risks should be covered: links to ERM and emerging risks  Models must be appropriate for the scale and complexity of the firm  Models must be dynamic and flexible  Models must be embedded in the financial, strategic and operational processes: Use Test in Solvency II  Governance of models development:  Board/top management oversight and involvement  documentation of models, limitations & changes  internal controls over development: auditable  independent review: More than peer review  Others:  consistency between valuation and EC models: valuation framework  input data verifiable and controllable  validation and calibration30/05/11 Enterprise Risk Advisory LLC
  8. 8. Major components  Exposure models of key risks:  financial risks & underwriting risks: assets and liabilities models cash flows  non financial risks: operational and business models  strategic risks: strategic models  Risk drivers models: ESG, catastrophic, scenarios, stochastic, EVT, competitor, behaviour, management actions  Aggregation approaches: correlation with var/cov, copulas, none  Time horizon: short-term view versus run-off approach  Confidence level: internal, regulatory, rating agencies  Frequency of calculations: quarterly to monthly  Valuation framework: economic, EV, EEV, MCEV  Metric chosen: VAR, T-VAR, EVT30/05/11 Enterprise Risk Advisory LLC
  9. 9. Uses  Investment decisions: existing and new  Product development  Strategic decisions  Corporate finance decisions: financial leverage  Hedging strategies  External events and emerging risks  Regulatory proposals: CP 37 & CP 56 in Solvency II  “…widely used and plays an important role in the course of conducting an insurers regular business, particularly in risk management. "30/05/11 Enterprise Risk Advisory LLC
  10. 10. Validation principles  Integrates both qualitative and quantitative elements  Provides that the models were designed, work as planned and are implemented correctly – quality assurance  Analyses the predictive properties of the models: testing against experience, back testing  Iterative process to assess that assumptions & data are appropriate with a certain degree of confidence: regular cycle  Need independence of validation to satisfy basic risk management principles: internal and/or external reviews  Must go beyond the pure regulatory ticking the box30/05/11 Enterprise Risk Advisory LLC
  11. 11. Validation elements  Model development, design, implementation and operations: similar to IT systems controls in place like COBIT  Review of models inputs:  assumptions & key risks  continuous appropriate mathematics and methodologies  data accuracy  Review of basic functioning of the models:  gaps to internal standards and best industry practices  model replication with a different set of random numbers  stress testing and reverse stress testing: sensitivity of the results  models capture business environmental changes30/05/11 Enterprise Risk Advisory LLC
  12. 12. Validation elements  Historical performance:  back testing to external sources: industry studies, academic papers, regulatory and rating agencies’ capital  Profit and loss attribution: comparison of actual results to risk drivers predicted by the models. Idem to a source of earnings analysis  Management oversight:  has management been using the models?  has management put in place processes to obtain assurance that the models are still appropriate  Documentation and independent validation30/05/11 Enterprise Risk Advisory LLC
  13. 13. Calibration principles  For each risk drivers, should aim to calibrate four elements:  level of the risk factor and its uncertainty  trend of the risk  inherent volatility  calamity/catastrophic/tail  Market conditions : impact on pro/counter cyclicality  Frequency of calibration: at least annually and probably more often for financial risks  Should be performed before hedging  Should be based on best assumption. No margin embedded as the purposed is to estimate required capital for the risks facing the organization  Time horizon and risk measures chosen per risk category30/05/11 Enterprise Risk Advisory LLC
  14. 14. Calibration by risk  Interest rate risk:  take into account the parallel , twists, inversion of the term structure  QIS4 tail up shocks: 94% at 1yr – low - to 40% multipliers at 10yr  interest rate volatility: usually set separately: * 1.5  Equity risk:  use different calibrations for publicly-traded, private equity, hedge funds, emerging markets  for publicly-traded: tail risk decline of 40% at 99.5%  for hedge funds: recent decline around 20%  implied equity volatility of around 35%  Currency risk: usually set around +/- 20% for a well-diversified portfolio30/05/11 Enterprise Risk Advisory LLC
  15. 15. Calibration by risk  Credit, counterparty & asset risk:  in a total return context, spread risk anticipates future defaults and migration. No need for an explicit default model  spread risk varies by type of assets, rating and currency  in Q1S4, spread volatility around 30% and shocks of about 90 bps to treasuries. Probably too low given recent experience  concentration risk must be assessed  for default risk: recovery assumption crucial in the 30% to 40% range30/05/11 Enterprise Risk Advisory LLC
  16. 16. Calibration by risk  Life underwriting risk:  QIS4 mortality rate increased by 15% permanent with a 2.5 additional per mille mortality catastrophe shock – debate in light of potential pandemic  lapse shock depends on impact. Can go as high as 100% multiplicative  longevity rate increased by a permanent 25%  Operational risk: must move beyond the factor based approach to modelling explicitly and map to insurance coverage and other internal controls  Liquidity risk: can be modeled and not simply managed  Contagion (systemic ) risk: Large FIs might be subject to additional capital if viewed as systematically important.  Strategic risk: can deplete capital and should be modeled  Reputation risk: doesn’t affect capital but value of the firm30/05/11 Enterprise Risk Advisory LLC
  17. 17. Correlation in the tail  Correlations exist at different levels:  within a risk category: Market Risk Interest rate Equity FX Interest rate 1 Equity 75% 1 FX 25% 25% 1  between risk categories within an entity  between legal entities for Solvency II: should probably be zero because of the non-fungibility of capital and the non recognition of group capital support30/05/11 Enterprise Risk Advisory LLC
  18. 18. Correlation in the tail  Recent experience seems to indicate otherwise  According to a recent Pimco study: Correlation Early Early 2008 Meltdown to S & P 500 90s 2008 % yearly loss S & P 500 1 1 37% High-Yield 20% 80% 26% Bonds -30% International 30% 70% 45% - 55% stocks -40% Real Estate 30% 60% -70% 37% Commodities 0% -20% -30% 37%30/05/11 Enterprise Risk Advisory LLC
  19. 19. Correlation in the tail: lessons  Correlations are unstable in the tail and this what EC is trying to determine  Independent risks become dependent in extreme times:  subprime business practices – operational risks ›  enhanced defaults - credit risk ›  market losses on securitized investments – market risk ›  capital problems at many FIs – liquidity risk ›  bankruptcies of many FIs – systemic risk ›  lawsuits by investors and regulators – legal risk ›  enhanced regulations – regulatory risk ›  diminished reputation for the financial industry – reputation risk and loss in value30/05/11 Enterprise Risk Advisory LLC
  20. 20. Correlation in the tail: lessons  “When people start buying an asset, the act of them diversifying ultimately makes the asset less of a diversifier .“ Pimco’s Head of analytics  Rule: total diversification benefit should not be above 30%  One potential approach is to use Clayton copulas which measure non-linear dependency  This is difficult as we trying to assess 1 in 200 year events30/05/11 Enterprise Risk Advisory LLC
  21. 21. Emerging issues  EC must be a forward looking process , tied to ERM and thus must anticipate emerging risks  Risk issues and impact on EC – mostly Solvency II  liquidity premium: not allowed in the calculation of the market consistent value of liabilities  discount rate: most likely the risk-free not swap rates  group support: not allowed and impact on diversification assumptions in EC calculation  MVM: currently set at 6% with no diversification benefit30/05/11 Enterprise Risk Advisory LLC
  22. 22. ERM: Emerging risk  Environmental risks – US based:  Fiduciary Responsibility: Legal and Practical Aspects of Integrating ESG Issues into Institutional Investment – UNEP FI  NAIC is requiring insurance companies with at least 500 million in annual premiums to start estimating and publishing an Insurer Climate Risk Disclosure Survey starting in May 2010.  NAIC seeks to determine "how insurers are altering their risk-management and catastrophe-risk modeling in light of the challenges posed by climate change. “ › direct EC implications30/05/11 Enterprise Risk Advisory LLC
  23. 23. Solvency II: ORSA  Pillar II requirement: Own Risk & Solvency Assessment  Goal is to demonstrate “sound and prudent management of the business and assess overall solvency needs”  Useful references:  BMA paper: “opopportunity to align management and regulatory reporting & encourage sound risk management practices within the jurisdiction”  CEIOPS: explains its preliminary views on the definition and importance of the ORSA as a management tool, requirements and guidance30/05/11 Enterprise Risk Advisory LLC
  24. 24. CONTACT MICHEL ROCHETTE, MBA, FSA ENTERPRISE RISK ADVISORY, LLC 954-607-6969michel.rochette@enterprise-risk-advisory.com

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